Bond prices fell, pushing yields higher. The pressure was too much for equities which declined along with the value of bonds. The 10-year Treasury yield closed within a whisker of 5%, its highest level since prior to the Great Recession. Earnings season rolled on with results roughly in line with expectations. While we saw a picture where during earnings season corporate fundamentals would dominate, the sharp rise in bond yields, which now surpassed the recent 4.5-4.9% range, rules the roost.
The obvious question is why have bond yields suddenly spiked. At the start of the third quarter, the yield on 10-year Treasuries was comfortably below 4%. 2-year notes were yielding close to 5%. Now the 2-year is closing in on 5.5%. Certainly, the level of uncertainty, both economic and political are factors. But market watchers have been on recession watch for months. At the most recent FOMC meeting, consensus built in support of an expectation that the odds of a soft landing, void of any recession, was increasingly likely. But with the recent spike in rates, chances for a soft landing are shrinking.
The hot topic today is an arcane phrase called term premium. Simply said, the term premium is the extra return bond investors need to get paid for taking duration risk. In normal times, this number increases with duration. 10-year bonds carry a greater term premium than 2-year notes. The term premium is easy enough to define but hard to explain. A critical factor affecting the size of the premium is inflation expectations. However, judging by the spread between TIPS bonds, which combine a base yield plus an inflation adjustment, and standard Treasuries of similar duration, inflation expectations have barely budged. In other words, the recent spike in yields cannot be attributed to fears that inflation is about to accelerate. Few expect it to rise at all. The Federal Reserve is intent on reducing inflation toward 2% and few doubt its ability to do so.
Some point to politics. Wars in Ukraine and along Israel’s border have raised tensions and risks. Some point to an expectation that foreign central banks are going to liquidate U.S. debt. But there is little evidence that’s the case. Since the European debt crisis a little over a decade ago, foreign central bank holdings have held remarkably steady, although as a percentage of U.S. debt outstanding their share has fallen as the amount of Treasury debt issued has climbed.
Certainly, the U.S. has rapidly increased the amount of debt it is issuing. Including the need to replace maturing debt, our government has sold almost $16 trillion of bills, notes and bonds through September, almost $3 trillion more than last year. Next year’s schedule suggests a further increase of over 20%, much of which will replace maturing securities. Ultimately the price of any asset is a function of supply and demand. And therein lies part of the answer. Assuming foreign central banks keep holdings near current levels, where are the buyers to pick up the incremental issuance? Banks are large holders but many have been burned holding bonds that have fallen in price as yields rose. In some cases, the unrealized losses on bonds held have come close to the bank’s equity. The bank failures this past spring, in part, were forced by similar unrealized losses. Regulators since then have pressured banks away from securities with more than minimal duration. Thus, banks have been net sellers of Treasury debt.
For most of the year, individuals have moved from equity to fixed income. That worked with rates high and relatively stable. But as rates started to spike, the depreciation in the value of bond holdings surpassed the incremental income earned. With the yield curve inverted all year, the appetite for long dated bonds has been depressed. Normally, Americans will absorb about a 3% increase in debt outstanding, consistent with normal GDP growth. But deficits today are running well over 6% of GDP and rising.
Thus, there is a strong argument that the imbalance of supply (Treasury debt outstanding) over demand means higher rates are needed to entice buyers. That’s true all along the curve. Today’s Fed Funds rate is 5.25-5.50%. Earlier this year, yields on very short-term securities (i.e., 6-months or less) were a touch higher anticipating more rate increases, while 2-year rates were a bit lower in anticipation that the Fed would start cutting rates before too long. But now the 2-year rate is at the top end of the Fed Funds rate range at a time when the majority of investors and economists think the Fed is not going to raise rates again.
When the Fed and Congress were dropping money out of helicopters, the term premium was negative. In Europe, actual bond returns were negative. But that has all changed as policies were tightened. Obviously, for whatever reason, if rates continue to rise while inflation falls, the real cost to borrow will become so large that borrowing will decline dramatically. Nowhere is that more apparent than in the housing market where 30-year mortgage rates are now near 8%. Economically, paying 8% at a time when inflation is falling toward 3% on its way to 2% means the only way that buying a home today makes good economic sense is if prices rise twice the rate of inflation or more. History suggests that’s a bad bet. Granted many buy homes for lifestyle reasons, not purely based on economics. But today, home sale activity is back where it was near the depths of the Great Recession. Student loan rates are now 5.5% and rising. Some private loans are over 10%. Rates matter.
GDP in the third quarter grew better than expected. The Atlanta Fed suggests it grew at 5% although most economists think growth was closer to half that pace. Even that is heady growth. So far, outside of housing, there have been no ominous signs that the higher rates have pinched demand. But unless rates pull back soon, it’s inevitable. It’s only a question of when.
Over the past week, there has been a noticeable correction within equity markets, particularly among cyclical companies including industrials, semiconductors, autos, and banks. Groups that had been weak, especially consumer staples, have performed better. The market may be sensing lower economic growth driving investors toward traditional safe havens. And, of course, the improved yields on short-term debt instruments are especially enticing.
Thus, stocks remain slaves to the bond market. Until the bond market finds stability, stocks won’t do particularly well. If inflation is headed for 2% and GDP longer term grows close to 2%, there is little reason to expect 10-year Treasury yields to rise far above current levels. Within a restrictive monetary policy, a term premium shouldn’t be much more than 1%. The actual number is hard to calculate; there isn’t a precise formula. But most place it today a bit below 0.5%. Wherever it ends up will determine the proper P/E for stocks. If one can safely get 6% for 2-year Treasuries or 5.5% for 10-year bonds, building a ladder that would return well over 5% for a number of years against a backdrop of inflation of less than 3% will be very appealing. For stocks to compete, their valuations would have to be compelling.
Vice-President Kamala Harris turns 59 today. Juan Marichal is 86.
James M. Meyer, CFA 610-260-2220